2014 July

Poroshenko ends a tentative ceasefire and launches military operations against pro-Russia rebels.

US and EU tighten sanctions on Moscow over its alleged involvement in the uprising in Ukraine.

A Malaysian airliner comes down in rebel-held territory, killing all 298 people on board. It is believed to have been shot down by a BUK-M1 surface-to-air missile shot from territory controlled by pro-Russia rebels. The UN Security Council calls for a full inquiry.

Red Cross says it considers Ukraine to be in a state of civil war.

EU leaders threaten to impose further sanctions on Russia if more access to MH17 crash site is not granted.

Pro-Russian groups hand over MH17's black boxes.

First bodies of the victims arrive in Kharkiv, Ukraine, to begin the journey home.

2014 August

Investigators from Holland and Australia begin a detailed inspection of the MH17 crash site.

2014 September

Kiev government signs ceasefire with pro-Russian leaders in eastern Ukraine. Under the terms of the Minsk peace plan, the Donetsk and Luhansk regions are given special status. The two separatist regions agree to hold local elections under Ukrainian law in December.

2014 September – November

There are repeated violations of the ceasefire on both sides.

Putin orders troop pull-back from Ukraine border.

2014 November

Ukraine and Russia strike gas deal.

Obama and Putin meet to talk sanctions.

The self-proclaimed "people's republics" of Donetsk and Luhansk hold early elections, in which two pro-Russian leaders are declared the winners. President Poroshenko describes the rebel-held vote as an "election farce" which he says violates the Minsk truce deal and jeopardises "the entire peace process".

The Kiev government, the US and the EU refuse to recognise the results of the Donetsk and Luhansk elections, but Russia says that they reflect "the will of the people of the south-east".

A double helping of slippery slope

After reading the above, it isn’t difficult to see why Russia over the last while has not exactly been the poster child for investor friendly economies. The graph below tells the story of recent Russian woes.

US Dollar to Russian Ruble Exchange Rate

Since the crisis started in March 2014, the Ruble has weakened approximately 31.5% against the US Dollar. Initially the CBR (Central Bank of Russia) attempted (halfhearted) currency intervention, but last month decided (rightly so) to let the currency float and only intervene “in extreme circumstances”. This move was wise and in our opinion will aid in reducing the extreme volatility we have seen.

However, it is our opinion that fairly benign neglect towards Ruble weakening together with the abovementioned announcement by the CBR regarding the curtailment in FX (Foreign Exchange) intervention signal that Ruble weakening may well be desired in order to promote import substitution. This should cushion domestic manufacturing and services, employment and the housing market, as consumers shift consumption away from imports toward domestic goods and services. It also mitigates the impact of lower commodity prices (see below).

It is clear that the geo-political events in Russia are enough to cause serious shock waves and one might be forgiven for thinking that Putin playing real life “Risk” is the sole reason for recent volatility in Russian markets, but, they would be wrong. While the geo-political and military drama has been unfolding as set out above, another well-known role player in previous games of global domination decided that it was tired of sitting on the side lines.

Oil…. glorious oil

Brent Crude Oil Price

The rout in the Crude oil price has been significant with the price of Brent Oil dropping approximately 34% since March. Russia is an energy-exporting nation (>50% of exports) and its economic well-being will always (for now) be at the mercy of the energy markets.

One would expect a spike in the price of a commodity when one of its main producers (that is, Russia) is in turmoil but in this instance oil has done the opposite. Since the beginning of the year, the oil price has dropped significantly and one can blame this on massive supply emanating from the US’s shale gas production, Saudi unwillingness to cut production to bolster price and, importantly, reduced demand especially from developed countries in the wake of emissions reduction agreements.

Indeed even the US and China, the two biggest consumers of oil worldwide, have pledged to deeply reduce Greenhouse Gas emissions.

However we believe that the upturn in oil prices are inevitable – many oil producing countries cannot sustain such low prices and indeed US shale is costlier to produce than Saudi oil, which should prices continue at current levels, will apply downward pressure on supply worldwide. What is clear is that OPEC has declared war on US producers by refusing to cut back production – something has to give and perhaps sooner rather than later.

What does the equity market think?

We all know that equity markets are in theory supposed to discount all future events to derive at their current values.

On the surface Lady Russia has so much baggage at the moment that to most people it is not worthy of any love or affection: capital flight, collapsing currency, bleak economic outlook, sanctions, falling oil prices, geo-political tension, inflation – need one say more!

It is a hard sell, but beauty is not skin deep. Even so, superficial investors have dumped Russia in their droves since July this year.

Russian Index Performance in USD terms

A bit of perspective: Russia is the world’s 8th biggest economy and as can be seen from the graph above, the equity market has dropped around 11 percent since the crisis began in March and around 22% since June. An interesting (but useless!) fact - as at the date of this article, Apple’s market capitalization is bigger than Russia's entire stock market (the 20th largest market in the world). What's more, as Bloomberg notes, there would be enough money left over after selling Apple and buying Russia to purchase over 190 million contract-free 64 GB iPhone 6 pluses (enough for every Russian).

But wait ... there’s more

There is a famous saying that goes: “the time to buy is when there is blood in the street.” (Lord Rothschild). We are firm believers in this mantra and for this reason alone Russia is worth a further look. However, besides a pure contrarian mindset the following should be noted.

Lower oil prices have been effectively offset by the weaker currency and for all intents and purposes, from a Russian perspective, the price of oil in Ruble terms equates to the oil price effectively staying the same as it was pre-crisis. This means that the Russian revenues from oil sales will remain unscathed in the face of the carnage. Sanctions will, however, lead to some import substitution and companies and banks will have to work far harder to raise offshore capital (to, amongst other things, settle its offshore debt). In addition, Mr Putin’s tit-for-tat strategy of banning food imports into Russia will contribute to inflationary pressure, however it will also develop the domestic market for food.

Further, oil prices, in our view, are set for a modest rebound as certain members of OPEC are unable to sustain the low price of oil indefinitely and US producers struggle due to shale gas’s relatively higher cost.

Russia has an extremely low debt to GDP ratio of approximately 13%. This is crazy small when compared with 101% and 76% for the US and Germany respectively. As such, even as interest rates go up and the currency continues to weaken, Russia is still very much able to meet its demands. Further, it is our view that unless oil prices stay consistently below 75USD per barrel, Russia will still maintain a current account surplus.

Currently it has USD370bn in reserves, a sizable amount to weather any economic storm it may need to face over the next few years.

We believe that based on our fundamental view, the Russian share market as a whole is significantly undervalued with the biggest value hidden in the energy, telecoms and banking sector. Based on current conditions and the use of a variety of relative metrics, we believe there is approximately 40 percent upside potential to be realised after the problems are resolved, sanctions are lifted and the situation calms down.

Where we will be “Putin” our money

Below are a few of the counters that we are flirting with – only time will tell whether we were naïve in falling for these Russian beauties or whether we have true love.

SBERBank -The largest bank in Russia has seen growth in earnings as well as corporate and retail loans despite the tough economic and credit conditions they face in the country. The gain in market share for loans means that it is perfectly poised for the eventual upswing. The Russian government is also a majority shareholder, which we think lowers the risk considerably. Think “too big to fail”.

Magnit – A discount retail chain in Russia, Magnit has already posted good growth results in spite of conditions. This can be chalked up to a resilience of consumer spending on staple foods; while other retailers focus on selling discretionary items, Magnit’s stores have 90% of inventory in food.

LUKOIL - The second largest oil producer in Russia; we believe LUKOIL is well positioned to take advantage of the pending upturn in oil prices. In spite of the poor currency performance, LUKOIL has 90% of its reserves in Russia, which means their costs are in Rubles but their revenues are in US dollars.

Yandex – The largest search engine in Russia with 60% market share. This company continues to grow and we believe that the current market presents a good opportunity to own shares in a solid company that is unfairly affected by investor fear.